Taxing IPR: The Direct Taxation Gamut
As is evident from the recent developments and media reports, the department of Revenue under the Government of India is inclined to bring more and more activities under the tax net. With the recent inclusion of service tax on renting of property, the revenue department has made this abundantly clear. The taxation of transfer or transfer of the right to use Intellectual Property (“IP”), though not recent, has many interesting twists and turns. Taxation of IPR as such is a complex question of whether it would be chargeable to direct taxation or indirect taxation and more so of how it is to be valued for the purposes of being taxed. The present bulletin looks at demystifying taxation of IP under the taxation regime in India.
1. Contentious issues
In order to assess the application of the direct taxation regime to IP, it will be beneficial to assess what category of expenses made in connection with IP fall under this regime. It is pertinent to note that IP in this regard would consist of Copyright, Goodwill, Trademarks and Patents, and under the Income Tax Act, 1961 (“IT Act”), the income derived from the IP is brought under the tax net. That being said, it is also noteworthy that IP itself is not taxable and is treated as an asset under the IT Act, making it chargeable to depreciation. In case of direct taxation, there are several contentious issues that arise vis-à-vis treatment of goodwill, capital or revenue expenditure, expenditure treatment of expenses associated with research and development and the like. The same have been discussed in greater detail ahead.
2. Valuation and tax treatment of Goodwill
Goodwill essentially has been held to be the component of total value of an undertaking which is intrinsically linked to its ability to earn profits over a considerable period of time owing to its reputation, location or any such factor.1 The transfer of goodwill of a business or profession that has been built over a period of time would not attract tax under the head „capital gains.‟ This is so since the goodwill has been created and the cost of acquisition is nil. The conundrum arises where goodwill needs to be segregated from the remaining IP for assessment of tax liabilities. In such cases, the value of goodwill will be the difference between the value of the assets and the actual consideration paid. Income from technical fees or royalty cannot be directly attributable to „goodwill‟ as unlike IP, goodwill cannot be licensed out.
Valuation of goodwill is quite recent with respect to its application in India. Internationally, the Generally Accepted Accounting Principles (“GAAP”) are applied or ascertaining the valuation of goodwill provides that it is an “umbrella concept” consisting of unidentifiable intangible assets not including IP which is capable of being identified individually and which can be sold. The IT Act was amended to bring in changes to specifically provide for goodwill as a capital asset, the sale of which would attract capital gains tax. There has been a long drawn debate of whether goodwill actually is an asset at all, and if so, should depreciation be claimed. As such, the conundrum still exists and as a matter of abundant caution, many companies have started the practice of showing separate valuation of goodwill under the balance-sheet, and claiming depreciation on the same was well. This helps companies avoid inflated valuations at the time of mergers and demergers and further simplifies the tax burden by allowing it to claiming depreciation.
3. Capital Expenditure vs. Revenue Expenditure
The confusion of whether the expenses incurred on acquiring IP forms part of revenue expenditure or capital expenditure was laid to rest by the Supreme Court‟s decision on L. H. Sugar Factory and Oils Mills (P.) Ltd. v CIT.2 In this case the court considered the threshold question for determining the tax treatment of expenditure on the development of IP; whether it is on income/revenue or on capital account. Expense undertaken for the creation of or for access to existing IP may be deductible under Section 37 of the IT Act as revenue expenditure. While expenditure of capital or of a capital nature is not deductible, capital allowance deductions may instead be available for certain types of expenditure on IP.
That being said there is a fine line of difference between Capital and Revenue expenditure under Section 37 of the IT Act. Several tests are available for determining whether a particular item of expenditure constitutes revenue or capital expenditure. The tests however, must be applied with proper regard and after appreciating the facts of each case, because no one test or principle or criterion is paramount or irrefutable or of universal application. Expenses incurred on the creation of IP can be written off as capital expenditure or revenue expenditure since there is a fine demarcating line between capital expenditure and revenue expenditure.
4. Research & Development
In India, the present tax regime provides for a favorable tax treatment of R & D expenditure. Herein, the Assessee has the option of adopting several methods when deciding how to treat R & D expenditure for tax purposes. Under Section 35(1) of the IT Act full deduction of expense for scientific research, not being in the form of cost of any land and building, is available. The term „Scientific Research‟ has been defined in Section 43(4)(i) of the IT Act as „any activities for the extension of knowledge in the fields of natural or applied science including agriculture, animal husbandry or fisheries.‟ Section 35(1)(i) grants deductions for revenue expenditure as laid out by the Assessee himself on scientific research related to the business, which should be carried out by the Assessee itself, or on behalf of the Assessee.
Further, as a measure of incentivizing expenditure on R & D, Section 80GGA grants a deduction in respect of donations made to a scientific research association, etc. approved under Section 35. Section 35(2AB) grants a deduction pertaining to expenditure on scientific research incurred by a company engaged in the business of biotechnology or in the business of manufacture or production of any drugs, etc. It is pertinent to note that in light of the tax regime applicable and while calculating the tax liability, practically the total expenditure on scientific research can be claimed as a deduction.
5. Capital Gains Tax & IP
Capital gains tax, under Sections 45 to 55A of the IT Act, pertains to the income that arises at a fixed point in time, namely the date of transfer of a capital asset, and is chargeable on the difference between the price at which it was transferred and the cost of acquisition of the asset. Specifically in case of IP, where the transfer of IP is on capital account, capital gains tax shall be chargeable. In a case where the IP was originally developed or acquired by the transferor through expenditure on capital account, that expenditure will form the base cost of the IP. However, if the expenditure was originally deductible being revenue expenditure and the transferor subsequently held the IP on capital account, the total amount received by the transferor shall be subject to capital gains tax.
In India, capital gains is further broken down into long-term capital gains, which would come into the picture only when the asset is transferred after 3 years, and short-term capital gains, which envisages transfer within a period of 3 years. Long-term capital gains are taxed at the rate of 20% while short-term capital gains are taxed at the rate of 30%.
6. Taxation of Royalties
A royalty is usually paid on the transfer of the right to use. For example, royalty has been stated to be compensation paid under a licence granted by the owner of a patent or a copyright to another person who wishes to use the same. The right which the owner has is an intangible commodity though the same is in respect of a material object, namely, a patent or a drawing. Commission or fee, on the other had is usually paid for services rendered by one person to another. Royalties fall under the ambit of „assessable income‟ for the purpose of Income Tax. Royalties in every case are taxable as „income from other sources‟.
Broadly speaking, the income deductable as contemplated under Section 80-O must be either for professional services rendered or a receipt for permission to use IP owned by the assessee. The section itself makes this amply clear as it states that the income which is received is to be in consideration, for use outside India, of any patent, invention, model, scientific knowledge, experience or skill. All this would fall under the category of, what is more commonly known as, “know-how”. That being said, tax authorities are becoming increasingly aggressive in scrutinizing the assessments since while many companies are claiming a deduction under section 80-O, the same are generating a large amount of royalty by way of licensing the IP.
In case of foreign companies, Section 44D of the IT Act makes a specific provision for allowing deduction for income by way of royalty or fees for technical services. This deduction is applicable only if the agreement under which the royalty or technical fee is
charged is made before April 1, 2003. The section deviates from the general rule of tax on income and not on gross receipts.
While it is generally accepted that tax on IP should encourage creation and innovation to create wealth and add impetus to the economic growth of the country, the reality is far from this. IP has still not been recognized as an accounting concept and effecting a change to this effect will greatly benefit and allow the tax system to cope in a business environment in which the value of intangible assets is actually being realized.
Leaving it to the assessee to decide what heads of taxation are applicable would only lead to increase in the conundrum. It would also not be possible to introduce a new legislation entirely for the regulation of IP and its taxation as the time it would take for the same to be implemented, newer concepts will arrive changing the dynamics once again. It would however be advisable if certain standards or yard sticks for determination of the nature of transaction can be put in place, as these will greatly assist the government as well as the assessee in determining the tax implications of the particular transaction being contemplated. Companies on the other hand must broaden their vision beyond creation and protection of IP to increase focus on “where” to create IP thereby to reduce the tax incidence on future transfer.
1 R. C. Cooper v. Union of India, A.I.R. 1970 SC 564.
2 125 I.T.R. 293 at page 298